9th August 2011

Thames River Multi-Capital Review - August 2011

What is driving the current market volatility?
The recent sell off in equity markets and corresponding flight to the perceived safety of government bonds was prompted by growing investor fears that the global economy, which had witnessed a softer period in 2011, would not recover as fast as expected and that any path toward improvement will now be a shallower and longer one. The downgrading in the rating of US debt by S&P over the weekend served to compound already negative near term investor sentiment.

Whilst in isolation a temporary stalling in growth might be manageable in market terms, the news comes on the back of a continued struggle by politicians and central bankers to manage highly indebted western economies with many fiscal and monetary levers having already been pulled. Investors have been aware of weaker growth since the start of the second quarter but until very recently, markets have been extremely resilient, expecting a more favourable outcome looking to the second half of 2011. The shock of more recent US GDP and ISM numbers has undoubtedly unnerved investors, at least temporarily.

Implications of slower growth
Any slowing trajectory in the economic growth outlook not only undermines the future potential profitability of companies and their dividend paying potential, but perhaps more importantly right now, limits the ability for companies and governments to restructure and write down bad debts, thereby prolonging the anaemic economic outlook further still. A particular risk to the US is they have targeted growth as a key strategy to tackle their debt problems whereas the UK for example, has chosen a path of austerity.

Recent economic data has accelerated these fears and comes at a notoriously more difficult time for markets with lower summer trading volumes having the potential to exacerbate share price volatility and this is what happened last week. Investor sentiment has very quickly moved to what can only be described as panic levels by historical comparison, taking stock market indices back to levels prevailing almost 14 years ago using the FTSE 100 Index as the measure.

What are we now thinking?
We are still of the opinion that economic growth will pick up in the second half of 2011, although the recent dent to government, corporate and private confidence levels along with the spike in the cost of capital for certain European countries probably means that the recovery will be less marked. This also suggests to us that the more optimistic predictions for share prices prevailing in the market some months ago are now quite demanding.

We do however stand by much of what we said in our last note sent out at the beginning of July; company balance sheets excluding banks are in rude health and are generally under leveraged, whilst dividend growth potential is good and likely to exceed inflation. Interest rates in the western world are now certainly destined to remain low for a prolonged period keeping debt servicing costs manageable whilst the expected weakness in commodity prices, likely to manifest as a function of the lower growth outlook, will ultimately act as a growth stimulant.

Equities do look good value
The relative value of equities looked compelling versus other asset classes at the beginning of July, particularly against bond investments. Although earnings potential may be somewhat compromised, with 10 year bond yields at or close to historic lows the case for equity investment is surely stronger than 5 weeks ago, assuming global growth does not contract substantially. This is most certainly not our central case.

Our view is that the collective global authorities are now going to have to get ahead of the curve with a range of options still available. This is increasingly likely to require a multilateral rather than unilateral policy response. If we don’t get this response and economic data continues to disappoint then further short term equity market weakness is probable. We do however believe that this is a correction and a significant one at that, but this does not presage a more serious slip back into depression. 

It is also worth sharing comments from recent meetings with many of the respected managers we talk to. During such interviews a notable feature has been that many businesses around the world were trading at compelling valuations with solid earnings, dividend and balance sheet support, even before this recent sell off, with many advocating buying into lower price levels as a very attractive entry point for the committed investor.

We also share one or two facts below that add support to our constructive analysis of the current situation:

• The UK dividend yield/Gilt yield ratio suggests equities offer compelling value over bonds with the ratio back to a level not seen in over 40 years.
• The price to forecast earnings ratio is back to the level prevailing in March 2009, just prior to the significant recovery in the stock market (source Financial Times 4 August 2011)
• The 10 year UK bond yield touched a record low last week suggesting to us extreme pessimism, even surpassing 2008 levels.
• Wall Street has never been more sure that the S&P 500 index will rally in 2011, even after speculation the US economy is heading for a slip back into recession – chief strategists at 13 banks from Barclays to UBS see the benchmark measure of American equities surging 17% through to December 31st, the average estimate in a recent Bloomberg survey according to IFA online.

At such times of economic and market volatility, through experience we have learned that to panic and react is often more dangerous than to sit it out. The longer the concern lasts, the greater the chances of the policy response and thus a significant snap back rally. It is also worth reminding investors of their time horizons and that a loss or reduced value on paper is only that if realised.

Further information
Of course if you have concerns, or would like to discuss any of these issues in more detail, we are always available to talk, so please do contact us:

Rob Burdett 0207 360 1368
Gary Potter 0207 360 1369 

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